[author: Caroline Grosch]
Yesterday saw the release of the first set of deliverables under the OECD’s project on base erosion and profit shifting (BEPS). These constitute the “building blocks” for an internationally agreed and co-ordinated response to government and media concerns in recent years about the perceived way in which shortcomings in relevant domestic and international tax rules allow modern multinationals to structure their activities to reduce their effective overall tax rate.
The OECD announced in early 2013 that it would embark on a project to look at ways to help countries to protect their tax base and ensure that profits are taxed where activities generating the profits are performed and value is created. In July 2013, the OECD published a detailed BEPS Action Plan which proposed action in 15 different categories, including strengthening relevant domestic legislation, amendments to double tax treaties, and increased transparency and disclosure. Yesterday, 3 reports and 4 instruments were released in respect of 7 categories. These cover some key topics, including addressing the tax challenges posed by the digital economy; neutralising the effects of hybrid mismatch arrangements; countering harmful tax practices; preventing tax treaty abuse; and transfer pricing. Our alert includes high level summaries of each.
The OECD states that the reports and instruments are agreed amongst all member states of the OECD, but there are still some issues to be resolved. Also, due to the interaction with the BEPS Action Plan deliverables due in 2015, the recommendations published yesterday will remain in draft form so that the potential impact of the 2015 deliverables can be incorporated before finalising them.
The OECD recommendations are a key item for the agenda at the G20 finance ministers meeting to be held later this week. The sheer scale of the BEPS Project is impressive. The question is whether it represents a turning point in the history of international co-operation on taxation.
Action 1 – Addressing the tax challenges of the digital economy
The OECD notes that the digital economy exacerbates the risk of BEPS. For instance, advances in technology have dramatically increased the ability to minimise taxation in a country receiving goods or services by avoiding a taxable presence. Another problematic feature of the digital economy is that it relies heavily on intangibles, which are very mobile, thereby allowing BEPS opportunities. The broader challenges of the digital economy relate to nexus, data (the reliance of business models on data) and the difficulty of characterising payments received in relation to that data and the value attributed to it. However, the problems do not lie with direct taxation alone. The digital economy also increases risks of BEPS in relation to indirect taxation.
The OECD has decided that it is not possible to deal with such issues by ring-fencing the digital economy from the rest of the economy; the digital economy is increasingly becoming the economy itself. Instead it will rely upon other BEPS workstreams to deal with the generic problems of BEPS so far as they impact on the digital economy. In addition, specific issues related to the digital economy will be dealt with under certain actions:
The work of Action 7 (preventing the artificial avoidance of permanent establishment (PE) status) will be expanded. This workstream is tasked with ensuring that “core activities” cannot inappropriately benefit from an exception from PE status. Issues to consider are whether activities previously viewed as preparatory or auxiliary in nature, or amounting to the maintenance of a warehouse, are actually a core activity and should be denied the exemption from PE status. In addition, the definition of PE may be amended to take into account artificial arrangements relating to sales of goods and services that involve contractual arrangements, eg whereby an online seller uses the sales force of a local subsidiary to negotiate and effectively conclude sales with large clients.
The transfer pricing Actions (8-10) are to consider the transfer of intangibles, data and the spread of global value chains in which MNEs integrate their worldwide operations.
Action 3 (strengthening controlled foreign company (CFC) rules) will consider whether the CFC rules should deal with the income typically earned in the digital economy, eg from the remote sales of digital goods and services.
The BEPS Project will also address opportunities for tax planning by businesses engaged in VAT-exempt activities by encouraging implementation of the OECD’s Guidelines on the place of taxation for business-to-business supplies of services and intangibles.
To deal with the broader tax challenges posed by the digital economy, by December 2015:
the OECD will look at ways to improve the collection of VAT in business-to-consumer transactions where low or no VAT is collected, either because of the exemption for importation of low value goods or the difficulty of enforcing VAT payment on remotely delivered services and intangibles;
the OECD will clarify the characterisation under current treaty rules of certain payments under new business models, eg cloud computing payments; and
the Task Force on the Digital Economy will continue to examine the broader challenges of the digital economy as regards nexus, data and characterisation, evaluate how the outcome of the BEPS Project impacts on these broader challenges and consider whether any further measures are necessary. The Task Force cannot prejudge this. During this period, it will refine potential further options to address any remaining challenges, eg creating a PE based upon significant (digital) presence in a market, creating a nexus for digital tax presence based on collection of data, and introducing a withholding tax on digital transactions.
Action 2 – Neutralising the effects of hybrid mismatch arrangements
Hybrid mismatch arrangements are used to exploit a difference in tax treatment of an instrument, entity or arrangement under the laws of two or more jurisdictions to produce a mismatch in tax outcomes. The effect can be double non-taxation or even a double deduction. For instance, hybrid financial instruments may be treated as debt in the debtor’s jurisdiction, giving rise to deductible interest payments, but as equity in the recipient’s jurisdiction exempt under the local participation exemption. The report released by the OECD under this action recommends changes to national rules and tax treaties to tackle hybrid mismatch arrangements.
The most important part of the report concerns the recommended national rules. The report recommends different sets of rules to neutralise the different kinds of hybrid mismatch arrangements. The report addresses the following kinds of hybrid mismatch arrangements:
hybrid financial instruments;
reverse hybrids; and
The rules are designed such that a tax mismatch is neutralised even if only one jurisdiction involved in an arrangement has appropriate anti-hybrid rules, while also ensuring that there will be no conflict between anti-hybrid rules of multiple jurisdictions. For instance, with respect to hybrid financial instruments, a primary rule requires that the debtor’s jurisdiction should deny a deduction if the payment is not recognised as “ordinary income” in the recipient’s jurisdiction due to the hybrid nature of the instrument. If the debtor’s jurisdiction does not have or does not apply the primary rule, then the recipient’s jurisdiction should, under a defensive rule, include the payment as “ordinary income” and refuse any dividend exemption.
Most of the anti-hybrid rules are targeted at transactions between related persons – the report recommends a revised definition of related persons, which abandons the 10% test muted in the discussion document issued earlier in the year. The OECD recognises that no consensus has been reached yet for certain areas of the report and that further work will be required in this regard. This is, in particular, the case for the application of the rules to hybrid regulatory capital that is issued intra-group. It is also not clear yet how the rules are to be applied in the context of CFC rules. As is the case for the other 2014 deliverables, the report issued under Action 2 may potentially be changed to take into account of recommendations made under the 2015 deliverables, eg the work on CFC rules.
Action 5 – Countering harmful tax practices
Action 5 revamps and refocuses the work of the OECD’s Forum on Harmful Tax Practices (the Forum), which was launched in 1998 following the OECD’s report, “Harmful Tax Competition: an Emerging Global Issue”. The concern is that tax havens and preferential tax regimes can affect the location of relatively mobile financial and service activities (including the provision of intangibles), erode the tax bases of other countries and undermine fairness and lead to a “race to the bottom”.
Action 5 requires the Forum to consider substantial activity as a key factor, alongside other key factors in the 1998 report, in determining whether a preferential regime is “harmful”. The interim report issued by the OECD under this action discusses a methodology for determining this substantial activity requirement in assessing intangible regimes. The methodology, which is not yet agreed between members, is based on nexus. It assesses proportionate expenditure so that the proportion of income that may benefit from an intangible regime is the same as the proportion between “qualifying expenditure” and overall expenditures. Under this approach, income would qualify under the regime to the extent that R&D activity is undertaken by the taxpayer itself. Once there is agreement on the methodology, the Forum will review the intangible regimes of OECD members in the light of the additional substance factor. The report also includes conclusions that certain non-intangible preferential regimes (including those in Luxembourg) are not harmful. However, these regimes may need to be reassessed in the light of the newly elevated substance factor.
The interim report also tackles transparency and sets out a detailed framework for compulsory spontaneous exchange of rulings related to preferential regimes. The framework, which has been agreed, contains a number of conditions for the exchange of information requirement to apply: that the rulings relate to preferential regimes, are within the scope of the Forum’s work, meet the no or low effective tax rate factor in the 1998 report, are taxpayer-specific and are either transfer pricing rulings or rulings that cover inbound or outbound investment or transactions, or a situation, involving other countries. This will enable other countries to check whether a ruling has any implications for the tax treatment of taxpayers in their jurisdiction. The Forum will review ruling regimes in OECD member and associate countries to determine whether the ruling regime is itself a harmful preferential regime and will identify which ruling regimes trigger the obligation to exchange information. The Forum will develop guidance on how the framework is intended to operate and will start to apply it from this autumn.
The report marks just the first phase of deliverables under this action. A further deliverable is due in 2015 in relation to the Forum’s work: expanding participation to non-OECD members.
Action 6 - Preventing treaty abuse
The BEPS Action Plan identified treaty abuse, in particular treaty shopping, as one of the main causes of double non-taxation. Not all forms of treaty abuse can be avoided under tax treaties based on the OECD Model Tax Convention due to insufficient anti-abuse rules. This is, in particular, due to the fact that the traditional purpose of tax treaties is to avoid double taxation and not double non-taxation.
The report released by the OECD under this action proposes to amend the OECD Model Tax Convention to include a series of specific and general rules to deal with tax treaty abuse. The main changes are the following:
The title and preamble of the OECD Model Convention will be changed to clearly state that the purpose of the tax treaty is not only to avoid situations of double taxation, but also situations of double non-taxation (or reduced taxation through tax evasion or avoidance).
The OECD recommends inserting limitation-on-benefits (LOB) provisions similar to those that can be found in tax treaties signed by the United States. The purpose of the LOB provisions is to grant treaty benefits only to persons that fall within one of the categories of situations identified in the clause as not representing a risk of treaty-shopping based on the activities, the legal nature or the ownership in such person. The application of LOB provisions is objective and there is thus little room for flexibility. However, the suggested LOB provisions include the possibility for a contracting State to grant treaty benefit to a person not fulfilling any of the other conditions in the LOB provisions if it determines, based on the facts and circumstances, that the transaction or arrangement does not have as one of its principal purposes the obtaining of treaty benefits.
The OECD recommends including a general anti-abuse rule in tax treaties pursuant to which contracting States may deny treaty access if it is reasonable to conclude, based on the overall circumstances, that one of the principal purposes of a transaction or arrangement is to get access to the tax treaty. The suggested general anti-abuse rule, which could be triggered even for persons fulfilling the LOB provisions, is very broad as it is not necessary that treaty access is the exclusive or the predominant aim of the transaction or arrangement.
It is clearly stressed in the report that these are only model provisions that need to be negotiated to take into account the specificities of individual States. Consequently, the suggested provisions may not be implemented in the same way by all the OECD Member States. The OECD acknowledges that not all States will be able to implement all the suggested rules as some may be incompatible with EU law or constitutional requirements. The OECD expects States to at least amend their tax treaties to clarify that their purpose is also to avoid double non-taxation.
Action 8 – Changing guidance on transfer pricing aspects of intangibles
Action 8 is aimed at developing rules to prevent BEPS by moving intangibles among group members and ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with value creation among the various members of a group. The OECD wants to eliminate cash boxes located in low tax jurisdictions, where the legal owner of an intangible performs few functions in relation to the intangible. The report released by the OECD under this action contains a series of final and draft revisions to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2010) (the Guidelines). The final revisions include changes to the Guidelines to clarify the definition of intangibles, provide guidance on identifying transactions involving intangibles, and provide supplemental guidance for determining arm’s length conditions for transactions involving intangibles.
The revised Guidelines give intangibles a broad definition as something “which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated […] between independent parties in comparable circumstances”, such as patents, know-how, trade secrets, trademarks, brands, licenses and goodwill. For goodwill, no precise definition is given, so taxpayers and tax administrations will have to analyse facts and consider whether third parties would have provided a compensation for such an intangible. Market specific characteristics and group synergies are excluded, but some guidance is provided on how these may impact arm’s length transfer prices and should be taken into account.
When determining the arm’s length price for the use or transfer of an intangible, the revised Guidelines provide that the following steps should be considered:
identification of the legal ownership and legal arrangements, which are the starting point of the transfer pricing analysis;
identification of the contribution of group companies to the development, enhancement, maintenance, protection and exploitation of the intangible in question: besides the legal owner, other members of the group may have contributed to the value of the intangible and must be compensated for their functions, assets and risks under the arm’s length principle;
confirmation of the consistency between the conduct of the parties and the legal arrangements by carrying out a functional analysis; and
identification of the nature of the controlled transactions involving intangibles, including the way in which such transactions contribute to the creation of value.
As mentioned above, the report gives supplemental guidance to the general framework for the determination of an arm’s length price set out in Chapters I – III of the Guidelines where the controlled transaction involves intangibles. Specific guidance is provided (partly in draft) on the transfer of intangibles or rights in intangibles and on the determination of an arm’s length price for intangibles whose valuation is highly uncertain at the time of the transaction. The CUP method and the transactional profit split methods are considered as most likely to prove useful in the case of a transfer of an intangible or right in an intangible, but the guidance also considers the use of valuation techniques and methods based on the discounted value of projected cash flows, for which it is essential to have accurate financial projections and assumptions. The revised Guidelines provide an impressive number of examples (33) illustrating the guidance on special considerations for intangibles.
It should be noted that the guidance on some transfer pricing aspects of intangibles has not been finalised at this stage. Some sections will be completed during 2015 in parallel with the BEPS work on risk, recharacterisation, capital and special measures (Actions 8 to 10).
Action 13 – Guidance on transfer pricing documentation and country-by-country reporting
In order to tackle the BEPS problem, ensuring greater transparency for tax administrations by providing them with adequate information to conduct transfer pricing risk assessments and examinations and allowing for better consistency of requirements for taxpayers is key. Guidance on transfer pricing documentation and a template for country-by-country (CbC) reporting aims to achieve this.
This guidance, which will replace the current text of Chapter V of the Guidelines, proposes a three-tiered approach to transfer pricing documentation that consists of a master file, a local file and a CbC reporting template.
The master file aims at providing an overview of the group’s business and will be shared among the tax administrations of all the countries where the group is located. It will contain, in particular, information on the group’s:
business, including a description of important drivers, details of any supply chain, main geographic markets, any important business restructurings and a brief functional analysis;
intangibles, including a description of the group’s strategy for the development, ownership and exploitation of these intangibles, a listing of these intangibles and the entities legally owning them and a list of the important agreements, such as cost contribution arrangements, license agreements or R&D agreements;
intercompany financial activities, including a description of the way the group is financed and the general transfer pricing policies related to financial arrangements; and
financial and tax positions.
The local file will focus on the information relating to specific intercompany transactions carried out by the local entity and will strive at demonstrating that the taxpayer has complied with the arm’s length principle. In that respect, it will include relevant financial information on the intercompany transactions, a comparability analysis and the selection and application of the most appropriate transfer pricing method.
The CbC reporting template, which will also be shared between the different tax authorities, will provide an overview of where profits, sales, employees and assets are located and where taxes are paid and accrued. This report, in particular, is useful for tax administrations to assess transfer pricing risk and to evaluate other BEPS-related risks.
The guidance also provides some recommendations on timing. The local file should be finalised when filing the tax return; the master file when filing the ultimate parent’s tax return; and the CbC report within the year following the end of the fiscal year of the ultimate parent. In relation to documentation updates, transfer pricing documentation should be reviewed on a regular basis, the benchmarking studies supporting the arm’s length character of the intra-group transactions should be updated every three years, and the financial data of the comparables should be updated every year.
Looking forward, over the coming months there will be some follow-up on the implementation of this guidance and, in particular, on the filing and dissemination mechanism for the master file and the CbC report. Guidance will also be revisited no later than 2020 to improve the documentation standards and verify if any additional reporting would be required, for instance with respect to interest, royalties and service fees made between associated companies.
Action 15 – Developing a multilateral instrument to modify bilateral tax treaties
A key issue here is how to implement BEPS changes in a quick and efficient manner without having to wait for further bilateral treaties to be renegotiated. Updating and amending each of the 3000 plus international bilateral tax treaties individually would be a highly burdensome and time-consuming task and the report highlights the need for changes to be brought in quickly to avoid creating further uncertainty.
To deal with this problem, under Action 15 the OECD recommends a multilateral instrument to implement tax treaty-related measures over a reasonably short period of time. This instrument would co-exist alongside, and modify, existing bilateral tax treaties.
The report examines the feasibility of this innovative treaty with no precedent in the tax world. It concludes that not only is it legally feasible based on an analysis of precedents from various other areas of public international law, but it is also desirable. Like existing tax treaties, this instrument would be governed by international law and would be legally binding on the parties. The OECD notes that flexibility could be retained in the instrument – countries could tailor their commitment under the instrument in pre-defined ways, with a commitment to a core set of provisions, together with an opt-in/opt-out choice for other issues covered by the instrument.
In January 2015, the OECD’s Committee on Fiscal Affairs will consider a draft mandate for an international conference for the negotiation of a multilateral instrument. The mandate will address who will participate in the negotiations, what topics will be addressed, when the negotiations will begin and on what framework the negotiations will be carried out. The international conference would be open to all interested countries under the umbrella of the OECD and the G20. An advantage of a multilateral instrument is that it can allow developing countries to benefit from multilateral efforts to tackle BEPS by signing up to the instrument. Once the recommendations for BEPS treaty-related measures are finalised in the context of the BEPS Project, they can then be considered by the international conference and included in the multilateral instrument.